Opinion: China’s devaluation sets up clash on trade, market reforms

Yin-Wong Cheung was taking a holiday in California from another uncomfortably warm August in Hong Kong, when the Chinese government tweaked the state currency, the renminbi. That pushed its value modestly lower, and unexpectedly toppled equity markets from Shanghai to London and New York.

“China—or the fraction (of its leadership) that pushed for such a move, underestimated the rippling effect,” says Cheung, a foreign exchange specialist, and chairman of international economics at the City University of Hong Kong.

Financial markets are value systems that distill two beliefs—confidence and hope—into price points. What has happened, in recent days, is that as China’s hopes eroded for domestic economic growth, global confidence evaporated in its high-flown equity prices, which even government-managed buying failed to prop up.

That fear has spread. But an even more fundamental challenge rests just ahead. That is the tension between the central bank’s efforts to keep a tight grip on the currency, and foreign exchange traders’ attempts to loosen it.

While the outcome is not in doubt—China is determined to move to a more market-oriented currency, and foreign-exchange traders will not be denied—this reckoning won’t be easily arrived. And there will be thrills, and spills, along the way. The latest drama offers only a hint of the action to come. After a consultation mission to China in May, the International Monetary Fund published an advisory recommending that China adopt a floating exchange rate within two to three years.

For now, keep an eye on the American worker because he and she may be among the first casualties of China’s devaluation that began Aug. 11. And don’t cast your ballot for U.S. president next year until your candidate expresses a satisfactory view on U.S.-China trade; and more to the point, on how to address the renminbi.

“China’s currency needs to appreciate further,” Treasury officials wrote, “to bring about the necessary internal rebalancing” of the state-directed economy from its dependence on foreign investment, to more domestic consumption.

China’s domestic consumption is equivalent to about 35% of its gross domestic product, or about one half the U.S. consumption rate.

By comparison, investment in China accounts for about 50% of GDP, compared to less than 20% in the United States.

That reliance on foreign investment combined with China’s slowing growth rate—the IMF pegs it at 6.8% this year, below the government projection of 7% , and falling further in 2016—has touched off a two-part panic, consisting of renewed intervention by Beijing in its currency and equity markets, and broader capital flight, including foreign investment and some domestic savings.

To make this clearer, it’s essential to grasp the renminbi’s dual quotations by state and private traders, and why this has created conditions for an export-enhancing devaluation, on the one hand, and flight capital, on the other.

The People’s Bank of China instituted a managed float of the renminbi in mid-2005—allowing it to trade onshore, in a gradually widening band against the U.S. dollar and other major currencies. But this local quote faces a growing challenge from a second market, now about one-third its size, just offshore in Hong Kong.

“The two markets tend to have different investor bases and liquidity conditions” and such “distinctive features” have “frequently caused the two exchange rates to diverge from each other,” according to a pair of working papers recently published by the Bank for International Settlements in Basel, Switzerland.

China’s efforts to reconcile its state-administered CNY to the privately traded CNH led to the downward adjustment of less than 5%, in mid-August.

“”Money has left China,” says Vinh Q.T. Dang—co-author of the paper, “China’s Capital and ‘Hot Money Flows,” published by the Hong Kong Institute for Monetary Research—because of “market participants’ skepticism of the 7% growth rate declared by the Chinese government for the first 2 quarters of this year” and continuing “challenges” to market reforms. “There is good reason to suspect” that the offshore CNH market forced the onshore CNY “to respond,” he adds.

Still, state officials don’t appear to acknowledge that by having opened the domestic credit spigot in July, their stimulus helped send the renminbi tumbling.

Zhang Xiaohui, a central banker, was quoted as saying that the “temporary loosening of liquidity”—as measured by bank loans last month—had put pressure on the currency, but “there is no foundation for the yuan’s devaluation to last.”

Dang, an economist at the University of Macau, responds, “Some new sources suggest that the (central bank, the People’s Bank of China) actually had to intervene to prevent further depreciation of the yuan. If you follow that market in the last few days, the yuan traded on the lower side of the permitted band.”

While Beijing struggles to sort out its problems, the U.S. government must be on guard so that Chinese influenza doesn’t turn into American pneumonia.

U.S. and IMF officials have argued, with limited success, in recent years for China to allow the renminbi to appreciate (not depreciate) faster. At the same time, China’s exports to this country have been more than $100 billion a year greater than normal market forces explain, according to Willem Thorbecke, a senior research fellow at Japan’s Research Institute of Economy, Trade and Industry in Tokyo.

Thorbecke contends that undervalued currencies among some of China’s biggest industrial suppliers, including South Korea and Taiwan, are a major source of the trade bulge. Essentially, China is able to cheaply buy components for the TVs and smart phones it assembles, and sells as finished goods to the United States.

Even so, Thorbecke estimates that a 10% appreciation of the renminbi alone would decrease China’s exports to the United States by 13.6% over the long term.

By extension, the recent devaluation is sure to heighten the trade imbalance—and related concerns, such as U.S. jobs and economic prosperity.

A few weeks before the devaluation, the U.S. Commerce Department found tiremakers in China had received subsidies of 20.73% (and up), to support the export sale of $2.3 billion in passenger vehicle and light-truck tires to America last year. The decision was remarkable for a number of reasons, among them that union workers brought the unfair-trade complaint; no U.S. tire company joined them; and the five-member U.S. International Trade Commission was badly divided.

Yet the example also highlights just how quickly the global trade picture turns on macro-adjustments, whether an expiring tariff (as in this instance); or a recalibration of foreign exchange rates, as more recent circumstances suggest.

Sen. Rob Portman, on behalf of nearly 1,000 workers at a Cooper Tire & Rubber Co.
CTB, -1.04%
plant in Findlay, Ohio, testified, “In September 2012, safeguard duties on passenger car and light truck tires from China expired. The impact was immediate. Imports from China surged back into the U.S. market, jumping by 66% in just the first quarter after the duties ended.”

“And these tire imports were not increasing because of market fundamentals,” the Ohio Republican argued. Rather, “unfair practices—selling below costs, and government subsidies—have made it possible for Chinese producers to consistently and deeply undercut U.S. tires, to the detriment of American workers.”

Cooper itself told shareholders in its 2013 annual report that “increased competition from imports” had reduced the sales volume of its North American operations. The International Trade Commission found that the tiremaker itself had benefited from a 20.73% subsidy, through cross-owned companies in China.

Cooper spokeswoman Anne Roman declined to comment, except to cite the company’s Aug. 6 earnings statement, which attributed a $137 million, or 15%, decline in second-quarter revenue to the sale of its Chinese joint venture.

The commission’s final report, published this month, is heavily redacted to protect company information and trade secrets. So specifics are in short supply.

Roy Houseman, a legislative representative in Washington for the United Steelworkers—which brought the trade complaint—bristles at China’s devaluation of the renminbi as one more obstacle for U.S. companies and workers.

“Devaluing currency like China has now done multiple times to boost their exports, provides another hurdle domestic companies must compete against, and that means lost jobs for union and non-union workers alike,” he says.

The City University of Hong Kong’s Yin-Wong Cheung, who is spending his California holiday watching markets unravel, adds, “There is no doubt about China’s determination to liberalize its financial markets. … On the other hand, once they do not feel secure—i.e. things are not under control—they step in and intervene.”

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